Wednesday, April 15, 2009

A lot of secondary criticism levelled at the Fed's policies have revolved around the massive tidal wave of inflation being built up and a fear that it's bound to launch an unforeseeable Weimar-republic style inflationary spiral that will end up putting us down for the count. In the short term, the deflation bugs are out, especially with the recent release of consumer CPI numbers of various vintages.

However, it's important to look at both sides of the equation and in this case supply and demand seems to be in balance (at least for now). As we have noted before, supply has been a little slower to react to demand in both an absolute and historical sense. Given that supply tends to lag a bit, this isn't surprising with regards to the absolute sense and given that the full nature of our recession wasn't understood until much later, this accounts for the historical lag.

Along with the CPI numbers, US capacity utilization numbers were released and much like many other numbers recently, came in more bearish than the consensus (down from 70.3% to 69.3%, under consensus by half a percent). As seen below, the fall in production has been pretty dramatic and the gap between production and capacity is at its highest level in almost 50 years. Currently we are producing slightly less than we were in 2002 - a lost 7 years that is likely to bounce back with a vengeance once the economy recovers.

Of course the real problem is going to be when the economy does recover. If production lags demand by a significant amount, we could indeed have a serious inflationary scare; especially if the recovery happens in the context of a less than perfect credit market, which is not an implausible scenario. On an emotional level, many manufacturers have been badly burned by inventory levels over the past year or so which is unlikely to help the situation very much - especially for low margin businesses, they are going to be much more gun shy to pick up production for the recovery.

The missing piece in all this of course, is international trade flows. As we have discussed before, US imports are unlikely to return to pre-crisis levels anytime soon and the overall trade flows are going to take a while to return to the levels that we know and love. External demand is unlikely to stimulate US production before domestic demand, which would have been a potential check against the inflation dragon. Overall, price levels in the US are going to continue to be primarily dictated by domestic forces, so the larger message and warning signs remain.

the PTB want inflation, plain and simple. good ole double digit 1970's bell bottom inflation. this mechanism will reduce the deficits and debt we all hold, and will be funded (isnt it always) by the lower 95% of the food chain.

sure, deflation now....but if you dont think inflation is coming, o lord i pity the fool.

This environment is not inflationary and will not be even if the economy recovers.

A hypothetical: suppose the Fed increases the monetary base by $100 billion. Banks now have $100 billion in reserves, but also suppose they have $2 trillion in unrealized losses from the decline in the value of their assets. It's very unlikely any of that "money" is going to end up purchasing goods and services. It will be neutralized on the spot, although as it is still a loan from the Fed to the banking system it will show up in the appropriate Fed column.

The only way the Fed can influence the economy with monetary policy is through the appropriate transmission mechanism. Thinking back to Econ 102, the story goes...

Fed increases reserves. Banks lend to business and consumers. Businesses invest. Consumers spend. The money gets put back into banks and the cycle repeats.

It's pretty clear this transmission mechanism isn't functioning at all, because despite zero interest rates and the most massive expansion of the Fed's balance sheet in history: investment is falling, bank lending is stagnant, and consumer spending is falling as well.

Even when the economy recovers, it's very unlikely we'll see significant inflation. Production capacity was set at bubble levels, and we're not going to see demand come back to those levels even in the next recovery. We've got impaired household balance sheets and an extremely impaired financial sector that may not get back to normal in my lifetime.

Certainly, the way we measure inflation is so narrow and messed up that we will probably see positive inflation of the CPI in a recovery. However, we're unlikely to see any increase in prices in residential real estate until we clear about two years of non-foreclosure inventory, and that's going to take years.

Japan was the same. When their economy recovered after the first 1990-1996 wave, they were able to paper over their insolvent banking system, inflation returned (barely) and the economy grew (slowly). But the bad assets are still there, and until they're worked out the capital can't be freed up.

Until then, any monetary stimulus is going to be pretty much sucked up to either cover lost capital or lend at below market rates, meaning those loans are going to eventually cost more than they bring in; adding to our pile of "legacy assets".

On the monetary front, Bernanke has literally doubled government-created money in the USA in a matter of months, but even so the ratio of private debt to this is close to 30 to 1. He’d need to create twenty times as much (and give it to the debtors to cancel their debts, rather than to the banks in a futile attempt to maintain their facade of solvency) before there would be any chance of a monetary stimulus working. I simply can’t see him trying it.

Even if he did (and our local RBA followed suit), and even if governments maintained the scale of fiscal stimulus they are now imparting, there would still be the reality (for the USA, the UK and Australia, and some European nations) that, courtesy of the globalisation of production, they no longer have the productive capacity to employ those who are going to be thrown into unemployment via this debt-driven collapse.

The problems caused by the neoclassical economic philosophy of the last 40 years were papered over by debt. To steal a phrase from Warren Buffett, now that debt is collapsing–and debt-finance can no longer be used to purchase cheap Asian goods–the nakedness of that philosophy will be exposed by the outgoing tide.